Firms traditionally issue conventional securities such as straight debt and common stock in order to raise capital. In general, straight debt securities (e.g., bonds, notes, loans, mortgages) enable firms to raise capital by borrowing and promising to repay a principal amount and interest on a specified future dates. Common stock securities, on the other hand, enable firms to raise capital by selling an equity interest in the firm. Owners of common stock typically receive voting rights regarding firm matters and may benefit through appreciation of the stock value and/or receiving dividends.
In addition to conventional types of securities, firms have a variety of more sophisticated hybrid investment instruments at their disposal. Hybrid securities may have attributes of several different types of securities (e.g., debt components and equity components) and may change optionally or automatically at certain points in time or depending on market conditions. Convertible securities, such as convertible debt, provide the issuer and/or the holder with the option of exchanging the convertible securities for other related securities, such as common stock. Convertible securities may be attractive to investors due to the mix of features, for example, earning interest like bonds when the stock price is down or flat and increasing in value like common stock when the stock price rises.
In some cases, a convertible security includes a contingent interest feature, in which additional interest is payable upon the occurrence of a specified condition. For example, the convertible security may provide contingent interest payments if the trading price of the bonds for each of the five trading days ending on the trading day prior to the first day of a period over which contingent interest may be payable is greater than or equal to 120% of the par amount for cash-pay bonds (i.e. bonds that pay interest) or 120% of the accreted principal amount for zero-coupon (i.e. bonds that do not pay interest) or discount bonds (i.e. bonds that pay interest and have an accreting principal amount). The first period for which a contingent interest may be paid may be the six-month period starting on the first date the bonds become callable by the issuer. The contingent interest amount may be a fixed percentage of the average market price of the bonds on the five trading days prior to the first day of such six-month period.
For tax purposes, if the terms of a convertible security provide for contingent interest payments, the issuer may take tax deductions based on the yield it would pay on a fixed-rate nonconvertible debt instrument with terms and conditions similar to those of the convertible security (“comparable yield”). The deductions are based on a schedule of projected payments with respect to the convertible security (“projected payment schedule”). The projected payment schedule is designed to produce a yield equal to the comparable yield. For accounting purposes, the issuer of the convertible security may need to establish deferred tax liability and deferred tax expense entries.
In every annual tax reporting period, for tax purposes, the issuer deducts a value equal to the tax adjusted issue price as of the beginning of the period times the comparable yield. The “tax adjusted issue price” as of the end of every period is the tax adjusted issue price as of the beginning of the period (issue price if the period is the first period), plus the tax adjusted issue price as of the beginning of the period times the comparable yield, minus any non-contingent and projected contingent cash payments to be made during the period. Deductions are adjusted upward or downward if the actual contingent interest paid is greater or less than that projected under the projected payment schedule. The tax adjusted issue price when the convertible ceases to be outstanding is compared to the value of securities and/or cash delivered to the holders to determine if the tax deductions are permanent.
By including a contingent interest feature, issuers can claim tax deductions in excess of the stated yield on the convertible security. Excess deductions may be recaptured as income if the issuer does not ultimately deliver to the holders securities with a value equal to or greater than the tax adjusted issue price at the time the convertible security ceases to be outstanding.
Typically, a straight debt (i.e. nonconvertible debt) security does not qualify for contingent payment debt instrument (CPDI) tax treatment. This is because straight debt instruments are usually based on either a fixed interest rate or a floating interest rate (e.g., the London Interbank Offered Rate (LIBOR), the swap rate, or some other benchmark interest rate). Straight debt instruments that include variable (i.e., floating) interest rates are generally treated as variable rate debt instruments (VRDI) and excluded from CPDI treatment.
It may be advantageous to an issuer, however, if a straight debt security could qualify for CPDI treatment. The following sets forth systems and methods for providing CPDI treatment for straight debt investment securities.